In the world of venture capital, there are certain investor rights that ensure the smooth execution of exit transactions. The primary such mechanism is the drag-along provision, under which one group of stockholders agrees in advance to sell or vote their shares in a sale of the company approved by another group of stockholders and/or by the board. Drag-along provisions often include a covenant by the drag-along shareholders not to sue over a drag-along sale, often including waivers of claims for breach of fiduciary duties. But are fiduciary duties of directors too important to allow them to be waived by stockholders? A recent Delaware Chancery Court decision puts guard rails on such waivers.
Drag-Along Provisions and Covenants Not-to-Sue
A drag-along provision compels a group of stockholders to vote in favor of a transaction approved by another group of stockholders and/or the company’s board of directors. A drag-along right can be particularly important in an acquisition where approval by all or almost all stockholders may be required. It can also be used to allow a minority of stockholders to drag the majority, which is often the case in the context of a VC-backed company where the drag-along may require most or all stockholders to vote in favor of any sale transaction approved by the investors.
Drag-along rights facilitate exits by preventing common stockholders from thwarting a sale of the company. The drag-along is most likely to be exercised if a company is presented with a modest acquisition proposal in which the common would receive little or no proceeds after payment of the investors’ liquidation preference. It could also be exercised any time the investors and common stockholders disagree about the merits of a potential acquisition. In such a scenario, the investors want the ability to force the common stockholders to approve a transaction the investors believe is in their (i.e., the investors’) best interests.
An increasingly common feature of drag-along provisions is a related covenant by the drag-along shareholders not to sue over a drag-along sale, including with respect to claims for breach of fiduciary duty. Without such covenants, shareholders in a drag-along sale, although powerless to stop the sale, could still bring claims for breach of fiduciary duty.
New Enterprise Associates 14, L.P. v. Rich
The plaintiffs in this case were VC funds (the “Funds”) that invested in a cloud security startup called Fugue, Inc. Six years later, the Funds encouraged management to seek a liquidity event. After a fruitless six-month search for a buyer, the company needed capital. When the Funds declined to invest further, the company’s only option appeared to be a recapitalization led by an investor named George Rich that would put his group in control of the company. Under the terms of the recapitalization, the Funds agreed to execute a voting agreement containing a drag-along right in favor of Rich and a related covenant not to sue Rich or his affiliates over any drag-along sale, including any suit for breach of fiduciary duty (the “Covenant”).
Certain conflict transactions occurred in the aftermath of the recapitalization. A potential acquirer contacted the company, and subsequently the company’s independent directors resigned. The Rich-controlled board then approved an issuance of shares to many of the original recapitalization investors at the same distressed price per share as their original investment. In connection with these issuances, the company allegedly failed to comply with the Funds’ right of first offer and to deliver a notice of stockholder action to the Funds under Section 228(e) of the Delaware General Corporation Law. The board then approved an issuance of stock options, mostly to themselves, with vesting provisions that accelerated upon a change of control.
Shortly after these interested issuances, the company’s management negotiated a merger with Snyk Limited, a cybersecurity company. The Funds were asked to join the merger, but declined when Rich and another director refused to attest that they had not communicated with the acquirer regarding a potential transaction before the recapitalization. After the merger closed, the plaintiffs learned of the conflict transactions and sued the company’s directors for breach of fiduciary duty.
In analyzing whether the suit should survive the Covenant, the court noted that this seems on the surface like an easy case for enforcement: sophisticated stockholders granted another investor a contract right to engage in a transaction that met specified criteria, and promised not to sue the investor or his affiliates if the investor exercised that right. The investor committed capital to the company in reliance on the stockholders’ promise. When the investor later exercised his contract right, the stockholders did what they agreed they wouldn’t do: sue over the transaction.
The court cited specific features of the Covenant that supported enforcement. The Covenant is sufficiently specific because it only applies to a transaction that meets identified criteria required for a drag-along sale. The Funds did not broadly covenant not to assert any claims for breach of fiduciary duty. They agreed not to sue over a specific transaction with specific characteristics. Accordingly, the court determined the Covenant is not invalid on its face.
The court also determined the Covenant is not invalid on the facts of the case. The court cited a series of dispositive factors from an earlier case, including (i) the presence of a written contract, (ii) the clarity of the waiver, (iii) the stockholder’s understanding of the waiver’s implications, (iv) the stockholder’s ability to reject the provision, (v) the existence of bargained-for consideration, and (vi) the stockholder’s sophistication.
The court found that on these factors, the facts of this case merit enforcement. The Covenant appears in a voting agreement. It is clear and specific. The Funds are sophisticated actors. The Covenant tracks a provision that appears in a model voting agreement sponsored by the National Venture Capital Association and widely used in the industry. The Covenant was part of a bargained-for exchange that induced Rich to lead the recapitalization, his fellow investors to participate and Rich and his colleague to serve on the board. If the Funds didn’t like the recapitalization, they could have blocked it, forced the company to seek different terms or funded the company themselves. If they saw no alternative but thought Rich had secured a great deal, they could have joined the investor group. Instead, they decided to pass, agreed to the Covenant and let Rich and his investor group take the risk.
Although the court determined the Covenant is not invalid on its face or as applied to the facts, it held nevertheless that the Covenant’s scope still stretched beyond what Delaware law allows. Delaware law generally prohibits contractual provisions that purport to exculpate a party for tort liability resulting from intentional or reckless harm. The Covenant purports to bar all challenges to a drag-along sale. According to the court, however, a covenant not-to-sue cannot insulate the defendants from tort liability based on intentional wrongdoing. In the context of opposing a motion to dismiss, the court determined that the plaintiffs’ allegations rely on facts supporting an inference that the defendants could have acted intentionally and in bad faith to benefit themselves and harm the common stockholders during the lead up to the drag-along sale. Consequently, the court ruled that the plaintiffs’ counts relating to the drag-along sale cannot be dismissed at the pleading stage, and denied the defendants’ motion to dismiss.
The New Enterprise Associates ruling against defendants seeking to enforce a drag-along covenant not-to-sue should be considered in its procedural context. On a motion to dismiss, the Court determined that the plaintiffs’ allegations relied on facts supporting an inference that the defendants could have acted intentionally and in bad faith to benefit themselves and harm the common stockholders during the lead up to the drag-along sale when they caused the company to issue to themselves allegedly discounted shares and options with accelerated vesting on a change in control, all while breaching the plaintiffs right of first offer and their own statutory obligation to notify the plaintiffs. This case thus involved unique facts pertaining to the run-up to a drag-along sale, not the sale itself, and it is unclear whether alleged misconduct pertaining directly to a drag-along sale will overcome an NVCA style covenant not-to-sue made by sophisticated parties. This case shows that the analysis into whether a drag-along covenant not-to-sue over fiduciary duties is enforceable is highly fact-specific, and investors and practitioners should strictly adhere to the criteria presented in this opinion.